We illustrate our analysis from the perspective of a CIO for a hypothetical $3b foundation. We assume the foundation is required to spend a minimum of 5% of its assets each year and that there are no anticipated external capital contributions. 

The graph on the right illustrates the portfolio’s performance-liquidity tradeoff for various cash levels, with and without a liquidity line. Without a LL, the portfolio has an expected return of 1.59%/y (net of spending) and 0% liquidity risk as measured by the probability of violating the CIO’s preset liquidity target. 

The CIO then considers reallocating some cash to illiquid assets, with higher expected returns, along with a LL capped at $40m (or 1.3% of the portfolio’s value). As shown in the chart, as the reallocation of cash increases, portfolio expected returns increase while liquidity risk barely 
budges. For example, with cash at 1.5% and a $40m LL, portfolio expected return increases to 1.65%/y.

However, once cash falls below 1.5%, liquidity risk increases rapidly.  Even with a LL, a 1% cash holding produces high liquidity risk.

While the expected return improvement in this example may seem small, the expected benefit can be scaled by increasing the size of the liquidity line.  

There are other benefits of a liquidity line.  Some CIOs hold liquid passive stocks and bonds for liquidity purposes because they are less disruptive to sell – and easy to repurchase. With a liquidity line, CIOs may be more willing to invest for alpha to improve returns. In addition, being a forced seller of assets to raise cash during stressed markets can impose a large cost (e.g., wide bid-ask spreads) on the portfolio, which is a permanent capital loss. An external liquidity source can help CIOs avoid such situations. Other potential benefits of a liquidity line may be harder to quantify, but are no less real. For example, a liquidity line may help CIOs avoid having to sell assets and disrupt external manager relationships which took time to cultivate and would take time to re-engage.   

While an external liquidity source can be an effective portfolio management tool, CIOs must pay careful attention to its terms and conditions (e.g., are there any additional costs? Are there any contingencies on changes in the portfolio’s assets or the financial health of the lender?)  CIOs also need to manage repayment so as not to create additional portfolio liquidity drains. In addition to a short-term liquidity line, CIOs could consider alternative liquidity sources such as repurchase agreements (repo facility) or a futures program (buying futures and selling assets) to raise short-term cash.   

A CIO can use this analysis to determine whether an external liquidity facility, and its size, could help improve average portfolio return while keeping liquidity risk under control.